Currency consequences: Brexit

August 23, 2016
Writer(s): Harry Choi, Andrew Pankevicius

Since Britain’s embark into the European Union in 1973, Britain’s relationship with the EU has been fraught. Thus, unsurprising to some, but a shock to many, Britain’s historic referendum result to leave the EU had a devastating impact on the global economy.

The event known as ‘Brexit’ saw Britain stripped of its top credit grade by S&P Global Ratings, reducing the previous AAA credit rating down two levels to AA as the country’s decision to leave the EU left the nation in a political and economic paralysis. The downgrade reflected “the risks of a marked deterioration of external financing conditions” and constitutional issues arising from the majority of voters in Scotland and Northern Ireland having opted to remain in the EU, according to S&P.

Similarly, other rating companies such as Moody’s and Fitch lowered their outlook for Britain due to the uncertainty surrounding the future of the nation. One particular aspect that the rating companies saw as the problem was the likelihood of “an abrupt slowdown” in economic growth. This is a result of the doubt that has cast over the citizens of Britain inciting a “rabbit in the headlights phenomenon” where businesses are hesitant to make new decisions or new investments. Hence, the slowdown of growth due to lower investment activities and lower demand for labour. Furthermore, considering that 48% of Britain’s exports go to the rest of Europe, the nation’s trade flows are anticipated to be considerably effected as it will no longer be able to benefit from lower tariffs and favourable market access that came with EU membership. The lack of freedom between Britain and the EU in terms of trade and market access will result in a fall in incomes between 1.1% and 3.1% according to a study by the centre for economic performance at the London School of Economics.

With fear of recession, the government is expected to enact monetary policy in the form of cutting interest rates to stimulate spending and investments in this uncertain nation. Amidst speculation that the central bank will lower interest rates to record low levels, this significantly affected global markets.

In order to understand the impact upon the foreign exchange and equity markets we need to look at the winners and losers after the “leave” outcome materialised. The New York Times reported on Friday that “betting against Brexit was so cheap that it was worth the risk for the brave with deep pockets” , so much so that those that mitigated their risk by purchasing these cheap short put options on the British pound won big. On the other hand, it may seem safe to assume that equity holders on the London Stock Exchange were the biggest losers as forward projections were being discounted across the board. It is also important to note that many funds leveraged their “remain” bets which amplified the losses incurred. However, these losses only caused trouble in the short term for fund managers as the persisting negative outlook for Britain’s future created a downward financial pattern that these institutions could utilise to recoup past losses though a focus on derivative financial instruments on interest rates, bonds, market indexes and most importantly, currencies.

With the British Pound now in freefall, a well-documented phenomenon known as the “flight to quality” took hold. Here, investors panic and move such a large amount of money out of one currency into another that they perceive as “risk-free”, in this case, the US dollar. Harking back to the basics of Economic theory, it makes sense that such a surge in demand for the US dollar would raise the USD:GBP exchange rate as diminishing supply in the US domestic currency market would expose the currency to a short term liquidity risk. Of course, these concerns are not exclusive to the price relationship between the USD and GBP, instead, it is inherently systemic to all currencies the USD trades with. Thus, even in Australia we saw our dollar drop relative to the USD.

Notice both the drop in the GBP:USD (yellow) and the smaller but still noticeable drop in the AUD:USD (blue) which occurs on the day proceeding the “leave” vote.

Not limiting our analysis to Britain, it is important to consider the fact that investors living outside of the UK who rely on long term British trade or are a creditor would also illustrate “flight to quality” behaviour to reduce their sudden increase in risk.

The current situation in Britain is indicative of an economic crisis in which the macroeconomic factors of unemployment, consumer sentiment and stability of future trade are uncertain and likely to head in a negative direction. Whilst the Brexit vote does not mean Britain immediately leaves the EU, this referendum outcome has directly affected British citizens undesirably through a possibility of a recession and doubtful economy.

The CAINZ Digest is published by CAINZ, a student society affiliated with the Faculty of Business at the University of Melbourne. Opinions published are not necessarily those of the publishers, printers or editors. CAINZ and the University of Melbourne do not accept any responsibility for the accuracy of information contained in the publication.

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